Page 1 of 5 CREDIT BUBBLE BULLETIN Only cure for a bubble
Commentary and weekly watch by Doug Noland
I commend Judy Shelton for her insightful op-ed piece, "Stable Money is Key -
How the G-20 can rebuild the 'capitalism of the future.'" It was published in
Friday morning's Wall Street Journal, a day ahead of "The G-20 Summit on
Financial Markets and the World Economy". As Ms Shelton noted: "One thing is
guaranteed: Most attendees will take the view that Wall Street greed and
inadequate regulatory oversight by US authorities caused the global financial
crisis - never mind that their own regulatory agencies missed the boat and that
their own governments eagerly bought up Fannie Mae and Freddie Mac
securities for the higher yield over Treasury's."
She continues: "At the bottom of the world financial crisis is international
monetary disorder. Ever since the post-World War II Bretton Woods system -
anchored by a gold-convertible dollar - ended in August 1971, the cause of free
trade has been compromised by sovereign monetary-policy indulgence. Today, a
soupy mix of currencies sloshes investment capital around the world, channeling
it into stagnant pools while productive endeavor is left high and dry ... If we
are to 'build together the capitalism of the future,' as [French President
Nicolas] Sarkozy puts it, the world needs sound money. Does that mean going
back to a gold standard, or gold-based international monetary system? Perhaps
so; it's hard to imagine a more universally accepted standard of value."
As much as I find the notion of sound money and a new gold standard
international monetary regime appealing, neither was part of any solution
coming out of Washington or the G-20 meeting of leaders of the world's top
industrialized nations last weekend or anytime soon. Fundamentally, our nation
has only a sliver of bullion available to back tens of trillions in financial
claims that are the crumbly bedrock for the entire global financial system. But
this is a moot point. The world may today disagree somewhat on how to parcel
out blame for the international monetary disorder, resulting in the worst
financial crisis since the Great Depression, but there exists a consensus that
concerted reflationary measures are the only possible solution.
There is little prospect that the direction of global policymaking will
engender the return of stability anytime soon. As Ms Shelton adeptly notes, "In
the absence of a rational monetary system, investment responds to the perverse
incentives of paper profits. Meanwhile, price signals in the global marketplace
are hopelessly distorted." To be sure, the market pricing distortions that for
years empowered Wall Street finance and government-sponsored enterprises these
days ensure that the US Treasury borrows and spends in egregious excess.
I think often of the great economist Dr Kurt Richebacher. My analytical
framework was over the years heavily influenced by his writings and mentoring.
He would always say, "The only cure for a bubble is to prevent it from
developing." Today's crisis confirms the brilliance of Dr Richebacher's work.
At the other end of the spectrum, conventional economic doctrine is revealed as
shallow and fatefully flawed.
I have repeatedly pointed to Milton Friedman's analysis of the causes of the
Great Depression as the keystone for our nation's deeply flawed economic
perspective. By the 1960s, there was an eagerness to cast blame for the
Depression on policy mistakes made in 1929 and subsequent to the crash. The
depression, it was determined, was not due to any weaknesses or vulnerabilities
associated with the credit system and market pricing mechanisms. Instead, the
1920s were conveniently recast as the "golden age of capitalism". Over the
years, Federal Reserve Board chairman Dr Ben Bernanke has repeatedly excoriated
the "bubble poppers" for their principal role in instigating the thirties
downturn.
Those of us who have studied the nature of the financial and economic
maladjustments engendered during the rampant credit excesses leading up to the
'29 crash take serious exception. Indeed, the Friedman/Bernanke/conventional
view of that historical bubble and bust has been a most dangerous case of
historical revisionism and flawed analysis. I am more interested today in
working to change failed economics than fingering blame for the crisis on our
public servants working desperately to avert collapse.
It is in this spirit that I am compelled to defend Treasury Secretary Hank
Paulson and his team at the Treasury. The severity of today's crisis is not the
result of policies - good, bad or otherwise - implemented over the past few
months. The greatest bubble in the history of mankind - nurtured by decades of
flawed economics, flawed finance, flawed policymaking and irresponsible
behavior throughout - is bursting and there is little our authorities can do
about it. Everyone was content during the boom to buy into the notion of
all-powerful Fed reflation and Washington stimulus, and we must now come to
grips with the reality that the entire framework advocating post-bubble
"mopping up" strategies was specious.
Secretary Paulson has been criticized for "making up the rules as he goes
along". Well, there is no rulebook for resolving this crisis. His policymaking
has been faulted - perhaps not undeservingly - for lacking transparency. Yet a
more substantive policy issue goes back 15 years: regulators looked the other
way and didn't demand transparency as the leveraged speculating community
borrowed trillions and accumulated massive holdings. Paulson and Bernanke
likely believed that an unprecedented US$700 billion government program to
acquire securities would provide the backstop bid to help restore market
confidence, securities prices, and lending throughout the economy. It simply
didn't work. Yet the system was heading toward collapse had they not moved
aggressively.
The Treasury, Fed, and the marketplace now appreciate that the system faces a
multi-trillion de-leveraging problem - not to mention the issue of new credit
creation necessary to avert economic collapse. The focus has, rightly, turned
away from the issue of impaired securities markets to a primary focus on
stimulating lending. The hope now is that the economy will receive a much
bigger bang for 700 billion bucks if it is used to recapitalize the financial
system rather than to acquire securities from distressed sellers. With the
securitization markets now essentially lost causes, the last hope rests with a
recapitalized and, supposedly, resurgent banking system. The expectation is
that $700 billion of additional capital can be multiplied into the trillions of
new loans vital to bolstering the economy going forward. It's not Paulson's
fault if it doesn't work.
We are witnessing policymaking out of desperation. Treasury has very limited
time, few alternatives and faces dire problems. It has become popular to point
out that the marketplace has lost confidence in Mr Paulson and his team. I
believe, however, that it is more aptly stated that the market has lost faith
in the prospect of policymaking generally having much influence on
developments. This is a consequence, as Ms Shelton reminds us, of upwards of 40
years of "monetary policy indulgence." Regrettably, G-20 policymakers at the
weekend hardly even paid lip service to monetary system reform.
Fundamentally, individual participant discipline is the nucleus of any stable
international monetary regime, whether it is the classic gold standard approach
or Bretton Woods system type of arrangement. The global abandonment of any
semblance of monetary or fiscal discipline is a hallmark of this extraordinary
period of bursting bubbles. Stable "money" may be the key - but it's also
nowhere to be seen.
WEEKLY WATCH
For the week, the S&P 500 dropped 6.2% (down 40.5% y-t-d) and the Dow fell
5.0% (down 35.9%). Economically-sensitive stocks were hit hard. The Morgan
Stanley Cyclicals sank 9.6% (down 54.3%). Transports dropped 4.7% (down 23.5%),
the Morgan Stanley Consumer index 3.6% (down 27.7%), and the Utilities 1.1%
(down 31.5%). The broader market performed poorly. The small cap Russell 2000
sank 9.7% (down 40.4%), and the S&P Mid-Caps fell 7.8% (down 42%). The
NASDAQ100 declined 7.2% (down 43.4%), and the Morgan Stanley High Tech index
dropped
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